We believe recent M&A activity indicating the first major combinations of traditional bricks-and-mortar retailers with major online retailers in the US has strategic implications, not only for the US grocery industry, but across broader retail segments.
US e-commerce continues to grow at a mid-teens percentage pace annually, while total US retail sales have grown at 3%-4%; e-commerce contributed 40% of total retail sales growth in 2016 (Exhibit 1).
Exhibit 1: Contribution of growth in eCommerce to total US retail sales growth in 2016
Source: Census Bureau Retail & eCommerce excluding motor vehicles and parts dealers, as of 10/08/2017
The growth in e-commerce is reflected in the performance of the internet and direct market industry, in contrast to that of the food retail industry (Exhibit 2).
Exhibit 2: S&P 500 industry total returns for the internet & direct market industry (which includes Amazon) and the food retail industry (where one finds Whole Foods Market)
Note: log scale (100 = 31/07/2002)
Source: Factset, as of 10/08/2017
Consumers shopping via their mobile phones have accelerated online penetration and growth. According to comScore, 80% of online sales in 2016 came from personal computers and laptops, while the mobile phone spend has grown from 2% to 20% in recent years. In a comparable period, online sales from mobile devices have grown by over 50% versus a 14% growth in purchases using PCs and laptops.
Some of the major online retailers have spent over a decade trying to build scale in the grocery and consumer packaged goods (CPG) categories. Unlike other retail verticals, they have struggled to migrate grocery and CPG spending online as up to 90% of consumers prefer to shop for their food in physical stores. Currently, less than 3% of the USD 1 trillion spent in the US on groceries and CPG is transacted online, making it one of the least penetrated online retail categories. For comparison, some European countries have online grocery and CPG penetration of up to 10%.
Greater online penetration driven by the expertise of online retailers
We believe the expertise in logistics and same-day delivery that online retailers have across major cities, combined with the stores of some traditional retailers, will help drive greater online penetration. There are other factors at play that we believe could further accelerate online retailers share in the grocery and CPG categories, including:
Changing consumer preferences and behaviour. There is a strong correlation between mobile penetration in a retail category and overall e-commerce penetration. With USD 200 billion in collective annual buying power, millennials (19-35 year-olds) are more comfortable buying online, and are influenced by social media (e.g. Twitter, Facebook, Instagram).
Expanding network of brands and categories that are looking for growth across new distribution channels.
Opportunities to accelerate private label brand growth. For example, online retailers have developed their own brands; there is also significant opportunity for online expansion of traditional retailers own brands.
New technologies and ways to purchase such as voice-activated ordering on Alexa/Echo and Subscribe and Save.
At this time, the strategy an online retailer would adopt with pricing and delivery are still unknown. However, grocery companies continue to view e-commerce as a strategic priority. Product innovation is also important, and they look favourably upon customer reviews (e.g., new product introductions) and analyses of consumer behaviour. In addition, branded companies such as Clorox have stated that they have a profitable business online, and to a degree that is not necessarily different than brick and mortar retailers.
Physical stores would improve density and last-mile delivery
The acquisition of a physical store footprint would provide an online retailer with a large retail presence, convenience options (e.g., same-day or two-hour delivery and buy-online-pickup-in-store), and allow them to further enhance services such as click and collect and tech-enabled checkout (without formal checkout).
According to Minneapolis-based M&A specialist Piper Jaffrey, a major online retailer in combination with one of the larger ‘old-economy’ grocery retailers could reach 63% of the US population within a 20-mile radius of their stores, up from 46% for the online retailer alone.
Grocery delivery economics have been challenging due to the number of stock-keeping units (or SKUs), fresh and perishable items, and the higher order frequency, which averages 80 per year compared to 60 for non-perishables bought online. As such, stores and distribution facilities offer an online retailer the potential to improve density and last-mile delivery.
We believe the acquisition of old economy CPG and grocery retailers would allow online retailers to compete more effectively and accelerate its ability to scale up much more rapidly as an omni-channel retailer in the grocery and CPG categories rather than as a standalone player.
With a large physical store footprint, same-day (two-hour) delivery infrastructure, supply chain logistics and consumer relevance and experience, we believe the move would further strengthen the ecosystem of the major online retailers. Over time, we believe that the online grocery spend has the potential to increase towards 10%, with the majors taking a bigger bite of the growing share.
A model for underpenetrated categories?
As to broader implications across retail, investors have been more concerned about the ‘online retailer effect’ in other large, underpenetrated categories. For example, since the first announcements of tie-ups between online retailers and ‘old economy’ CPG and grocery retailers, partnerships have been announced with manufacturers of sporting goods, household appliances, as well as in-home installation services (e.g. smart home products, furniture, appliances).
Furthermore, media reports have sparked concerns across the pharmacy, restaurant delivery and premium cosmetics segments. And all this comes at a time when US bricks-and-mortar retailers are already facing headwinds such as an increasing shift towards e-commerce, retail stores closing and rising bankruptcies, as well as seismic shifts in consumer behaviour and preferences (see Exhibit 3 below).
Exhibit 3: US eCommerce sales as a percentage of total US retail sales and the performance of Amazon and department stores relative to the consumer discretionary sector (XLY) of the S&P 500 index
Source: US Census Bureau, as of 10/08/2017
Nevertheless, while it is too early to assess all the strategic implications and potential winners and losers from possible combinations, we believe retail markets will continue to provide us with investment opportunities across the consumer landscape (Exhibit 4 shows year-to-date (as of 11/08/17) absolute and relative returns (relative to the S&P 500 consumer discretionary index) for selected companies).